How Fannie & Freddie Debt Is Counted In Bank Stress Testing

The Federal Reserve plans to stress-test Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo against a worsening of Europe’s sovereign debt crisis and other hypothetical global market shocks. The central bank plans to publish the results next year. They are clearly worried about the issue of Europe. At least commercial banks and savings institutions insured by the FDIC are making money: they reported an aggregate profit of $35.3 billion in the third quarter of 2011, an $11.5 billion improvement from the $23.8 billion in net income the industry reported in the third quarter of 2010. This is the ninth consecutive quarter that earnings registered a year-over-year increase.

“Ongoing distress in real estate markets and slow growth in jobs and incomes continue to pose risks to credit quality,” Acting Chairman Gruenberg said. “The U.S. economic outlook is also clouded by uncertainties in the global economy and by volatility in financial markets. So even as the banking industry recovers, the FDIC remains vigilant for new economic challenges that could lie ahead.” As was the case in each of the last eight quarters, lower provisions for loan losses were responsible for most of the year-over-year improvement in earnings.

For the geographically challenged, Basel, Switzerland is in Europe. The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of several large countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee also frames guidelines and standards in different areas. As the FT says:

Under the global Basel III rules, which will be phased in between now and 2019, banks have to hold top quality capital equal to 7% of their assets, adjusted for risk. The biggest banks will also be hit with an additional surcharge of up to 2.5%. Banks in the European Union will also have to hit a temporary 9% ratio next year after discounting their risky sovereign debt holdings.

But US banks are asking for weakened Basel III rules (FT excerpts and link below).

Basel III’s capital requirements, of course, is one of the reasons servicers (like GMAC) are either shifting servicing values, selling servicing, or deciding they don’t want it anymore period.

US lenders are urging financial regulators to ease new international bank liquidity rules as the industry faces a collective shortfall of $1.4 trillion for complying with the new regulations.

…American banks are at a disadvantage to their foreign peers because the regulatory response to the financial crisis limits the kind of assets US companies can use to show they could withstand a 30-day bank run … The package of reforms, known as Basel III, includes a provision that requires banks to hold enough cash-like assets to survive a month-long crisis. Lenders in the US and in Europe have argued that the “liquidity coverage ratio” is too stringent and would limit lending.

…The Clearing House urged US regulators to relax implementation of the Basel standards because they unfavorably treat debt and mortgage securities issued by Fannie & Freddie.

…While cash and sovereign debt can be used to meet the entire liquidity requirement, Fannie and Freddie securities, covered bonds and high-quality non-financial corporate bonds can only count towards 40 per cent of it.

…Fannie and Freddie securities are generally regarded as more liquid instruments than covered bonds. We have a little time: the liquidity rule will not go into effect until 2015. In response to complaints from lenders, financial regulators agreed to fine-tune the liquidity standards, where needed, by 2013.

Bill R. wrote to me, “When Basel III took over it rigged/leaned the banking systems rules and regulations toward the larger banks awash in global CDS and CDO’s. Left swinging in the wind were smaller banks forced to stand on their own feet, their own balance/income statements without the support of Government bailouts. This is what the unknowing useful idiots on WS are jumping up and down about.”

Across the Pacific, Australia’s major banks are preparing to issue covered bonds to enhance liquidity-risk positions as Basel III rules loom. “The two major benefits for Australian banks issuing covered bonds are access to lower costs of funding and a move to a more stable longer-term source of funding,” said William Mak, credit-desk analyst at Nomura. “Covered bonds will also have implications for the net stable funding ratio as banks shift to longer-term stable funding required under Basel III liquidity reforms.”
___
Reference:
FT: Fed Sets US Banks Toughest Stress Tests
FT: US Banks Ask For Weakened Basel III Rules
TheBasisPoint: Time To Dump Basel Bank Capital Rules?